As Deficit Countries Contract, Can Surplus Countries Be Far Behind?

The US loses the most jobs since 1945, the Financial Times headline blared out yesterday. According to the article:

The US economy lost more than half a million jobs in December for the second month running, figures showed on Friday, making 2008 the worst year for job losses since 1945 and intensifying pressure on Congress to pass a fiscal stimulus. The number of jobs lost during the year reached 2.6m, while the unemployment rate – 4.4 per cent before the credit crisis – jumped to 7.2 per cent in December, its highest level in 16 years.

Yesterday’s Telegraph was not a whole lot warmer on the subject of Europe. It had an article entitled “Europe’s economy contracts at rates not seen since 1930s,” which started off with:

German exports and industrial orders have both plunged at the steepest rate since modern records began and Spain’s unemployment has surged above three million, capping one of the most disastrous days for Europe’s economy since the Second World War.

It is pretty obvious that consumption in trade deficits countries is adjusting at a breakneck pace – “adjusting” being a word often used by economist’s to mean “the party’s over”. The rising savings rate required by households to repair tattered balance sheets has not just meant an equivalent decline in consumption, since this rise is occurring so quickly that income is declining. The total drop in consumption is, and will continue to be, severe.

With consumption declining so quickly, and fiscal spending so far unable to keep pace, what deos this do for countries exporting excess production? In some trade surplus countries – i.e. Germany – the predictions some of us had been making about the “second stage” in the crisis, in which trade surplus countries get hit with deeper and longer-lasting adjustments, seem already to be coming true. Exports are collapsing, and with no increase in domestic demand to compensate, it is pretty hard to imagine how businesses are going to cope.

For all the attempts by the government to keep confidence up, Chinese businesses, not surprisingly, are worried. Yesterday’s South China Morning Post had the following article:

Business confidence in the mainland plunged in the final three months of this year to an eight-year low as the mounting effects of the financial crisis weighed on exports and industrial output, an official survey showed on Friday. The business confidence index fell 29.2 points in the fourth quarter to 94.6, the National Bureau of Statistics said. That is the lowest reading since the start of 2001, the earliest date for which official figures are available.

Hardest hit were manufacturers, hurt by shrivelling demand in the United States and Europe and a weakening domestic property sector. Their sub-index plummeted 32.1 points from the third quarter to 87.2. That reading is in line with two purchasing managers’ surveys published earlier this month, which showed a continued contraction in the sector, as well as economists’ expectations that exports shrank more quickly in December.

The debate locally about what caused the trouble and what to do about it (and not incidentally, who to blame) continues strong, and recently two things seem to have been added to the stew. One, the China-trade-imbalance argument has gotten enough traction within China that suddenly the debate seems to have erupted into the spotlight. A number of local analysts, especially critics of both the left and the right, have been arguing that Chinese monetary and fiscal policies may have been part of the root cause of the imbalances that led to the crisis.

Regular blog readers know that I won’t find this argument at all surprising, but local policymakers are inordinately sensitive to being blamed for anything, and the official position is that China is simply an innocent bystander in a problem wholly concocted and hatched elsewhere. However an increasing number of Chinese economists and academics seem to be challenging that position, so much so that the People’s Daily posted a rather angry editorial three days ago titled “U.S. blame game cannot change facts of financial crisis.” The article blasts Paulson and Bernanke for saying that “a failure to address the rise of emerging markets and resulting imbalances was partly to blame for the global financial crisis,” and concludes:

Imbalances in global trade and investment did have a role in the crisis but were not at the root of the problem. Loose supervision that helped pump excessive dollars into circulation was the root cause. When a morally upright person is mired in difficulties, he or she will engage in introspection rather than shift responsibility. China has moved to cope with the problem with a stream of measures and so have other large world economies.

It is not time to play a blame game. Regulators in the United States might not want to miss the chance that they failed to seize before the crisis, when property companies, investment banks and insurance companies juggled various financial products and Wall Street “elites” snatched tens of millions out of the bubble.

It is hard to argue with these conclusions, but a cynic might wonder if any of the participants in the crisis would be considered, by this argument, “morally upright.”

The second thing we seem to be hearing a lot of is concerning capital flows and whether or not China is experiencing hot money outflows. We are all still trying to figure out what is happening to capital flows and to the composition of reserve accumulation (or is it reserve dissipation?). In a recent note, Logan Wright of Stone & McCarthy tries to back out the things we know to get some sense of what is happening to capital flows.

He concluded in an email to me that was attached to his research report that “outflows of around $100-150 billion for the quarter seem within the realm of possibility, but we won’t know anything until we see the data,” but was at pains to establish that he is only guessing. His guesses would be easier to dismiss if a SAFE official hadn’t made a rather surprising announcement four days ago. According to Bloomberg:

I accidentally erased the article and can’t get it back, so I can’t quote much more from it, but I do remember finding the whole thing a little odd. There was no clear explanation of what was “abnormal”, but all the evidence suggests that money flows are not behaving as well as we would want them to. Other interesting official commentary last week included the following, from an article in Tuesday’s South China Morning Post:

The mainland’s financial position will be difficult in the year ahead as revenues fall and spending surges, Minister of Finance Xie Xuren warned yesterday. Painting the most sombre picture of the government’s finances in years, Mr Xie said that shrinking corporate profits caused by rapidly slowing economic growth, as well as tax cuts, would lead to a drop in revenue, while government measures to boost growth would add to spending.

“[It] will be a very difficult year,” Mr Xie told an annual national meeting on fiscal affairs in Beijing. “The problem of unbalanced income and expenditure will be prominent in 2009.” His warning came as an official revealed that the mainland’s giant state-owned enterprises had reported a rare decline in profits last year. “Profits of state-owned enterprises directly under the central government fell about 30 per cent year on year in 2008 to 700 billion yuan [HK$800 billion],” said Huang Shuhe , vice-chairman of the State-owned Assets Supervision and Administration Commission.

Some of my older readers will remember last year when I argued that something a lot of analysts saw as a real strength – the huge surge in China’s fiscal revenues, which left the fiscal account more or less in balance – was, in my debt-trader-influenced pessimist’s eyes actually a real problem. If the fiscal account stayed in rough balance with fiscal revenues soaring by 30% a year, it seemed to me that any discrepancy between the rate of revenue growth and expense growth could lead to a sudden unexpected rise in the fiscal deficit, especially since in a downturn the pressure for revenues to decline and for expenses to rise would be unbearable.

The probability geek in me instinctively worries about very rapidly changing numbers, even when they are good, because there is a lot more room for things to go very bad. From what Mr. Xie is saying, the worry was on the mark. The growth rate of fiscal revenues and fiscal expenses have already sharply diverged, and this is even before the big spending plans have been put into place. The article goes on to say:

Ha Jiming , chief economist at China International Capital Corp, said the weakening financial position would cast doubt on the government’s much-vaunted economic stimulus package. The measures, including the 4 trillion yuan stimulus package and tax cuts, are to stem a rapid slowdown in economic growth, by boosting public spending and private consumption.

It claims that economists “expect the mainland will have a budget shortfall this year, with the deficit between 500 billion and 800 billion yuan.” I am nowhere near smart enough to predict what the deficit will be, but I am happy to bet anyone it will be a lot more than the current predictions.

Finally one last comment about recent interesting, and even surprising, government statements, is about a report last week in Laiowang, a Xinhua publication. According to an article on the topic in South China’s Morning Post:

The mainland faces surging protests and riots this year as rising unemployment stokes discontent among migrant workers and university graduates, a state-run magazine said in a blunt warning about unrest in this sensitive year. The unusually stark report was in this week’s Liaowang [Outlook] magazine, issued by Xinhua news agency, which laid out the hazards facing the mainland and ruling Communist Party as growth falters during the global economic crisis.

“Without doubt, now we’re entering a peak period for mass incidents,” a senior Xinhua reporter, Huang Huo, told the magazine, using the official euphemism for riots and protests. “In this year, Chinese society may face even more conflicts and clashes that will test even more the governing abilities of all levels of the party and government.”

This report has been so widely discussed that I don’t have a whole lot to add to it.

My last comments are about two recently published pieces. On Economists Forum on the Financial Times website Martin Wolf published my short version of a longer article also published yesterday in Far Eastern Economic Review on the global balance of payments and the US-Chinese adjustments.

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.